The 2017 Tax Bill’s Pass-Through Deduction Largely Favors the Wealthy and Encourages Gaming of the Tax Code

The 2017 tax cuts, signed into law by then-President Donald Trump and enacted with no Democratic support, made deep cuts to personal, corporate, and estate taxes that were heavily skewed to the wealthy.¹ One of the law’s changes allowed owners of pass-through businesses—partnerships, sole proprietorships, and S corporations—to deduct 20 percent of their qualified business income (QBI) when calculating their taxes.² The pass-through deduction was one of the most costly provisions of the 2017 law—initial estimates projected that the new deduction would cost $414.5 billion—and the Congressional Budget Office estimates that extension beyond the provision’s 2025 sunset would cost $684.2 billion from 2025 to 2034.³

As described below, this pass-through deduction is costly, has failed to produce promised growth, disproportionately benefited the wealthy, and has encouraged businesses to game the tax code to maximize qualifying income. For these and other reasons, Congress should soundly reject extension of the provision.

The benefits of the pass-through deduction heavily skewed toward the wealthy. Tax filers with adjusted gross incomes (AGI) of $500,000 or more in 2021—the top 1.5 percent of filers—claimed more than half of all pass-through deductions, despite accounting for just 6 percent of all returns with the deduction. Moreover, wealthy filers claimed substantially larger average deductions—$1,024,246 for those with AGI of $10 million or more. By contrast, filers with AGI below $100,000 with the deduction—who accounted for 51 percent of claimants—claimed, on average, $1,997. (see Figure 1)

Taken together, the disproportionate use of 199A by the wealthy, coupled with larger average deductions, resulted in a sizable majority of the tax cut going to the highest-income households.¹⁴ According to the Joint Committee on Taxation (JCT), nearly two-thirds of the 2019 decrease in taxes—64 percent—went to households with incomes of $409,836 or more, roughly the top 1.5 percent of the income distribution.¹⁵ The JCT further projects that more than half of the tax benefit from 199A—$31.6 billion out of a total of $60.3 billion in benefits—received in 2024 will go to millionaires, who account for just 1 percent of those claiming the tax break.¹⁶

Over the past four decades, the share of U.S. business income generated by pass-through businesses has increased substantially, and in 2015, the latest year for which comprehensive data are available, pass-throughs accounted for nearly two-thirds—63 percent—of all business income.¹⁷ And because pass-through income is concentrated and has increased most substantially at the top of the income distribution, this shift has helped fuel widening inequality.¹⁸

The rise of pass-through businesses was fueled by tax laws that favored pass-throughs—which are taxed once at the owner/shareholder level—relative to C corporations.¹⁹ These provisions—including the Tax Reform Act of 1986 and state and federal law changes that allowed for the creation of structures that grant the protection of limited liability to noncorporate entities, including partnerships—encouraged businesses to organize as pass-throughs to lower their effective tax rates.²⁰ While C corporation income more than tripled from 1980 to 2015, pass-through income rose more than 23 times over, with partnership income increasing nearly tenfold. (see Figure 4)²¹

Although stereotypically considered “small businesses,” many pass-throughs are, in fact, quite large. In 2019, more than three-quarters—77.3 percent—of partnership assets were held by partnerships with more than $100 million in assets, as were more than one-third of S corporation assets.²² High-wealth partnerships in finance and insurance (62 percent of partnership assets) and real estate (20 percent of partnership assets) accounted for a large share of these holdings.²³ While many of these partnerships have relatively simple structures, a sizable fraction are complex, with multilayered structures, sometimes involving offshore tax havens, that are difficult for tax administrators to untangle.²⁴

While large businesses account for the largest share of pass-through assets, analysis published by the JCT shows that nearly half—45 percent, or $92 billion—of 2021 199A deductions were attributable to businesses with no employees.²⁵ Notably, more than 90 percent of the sole proprietorships and more than 80 percent of partnerships that claimed the pass-through deduction in 2021 had no employees.²⁶ In these instances, the JCT report notes that “the prevalence of entities with no reported employees may be attributable to several factors, including contract and gig workers that are not counted as employees and sole proprietors that do not pay themselves W-2 wages.”²⁷

The owners of these “no employee” pass-through entities are, in the words of Department of the Treasury economist Matthew Smith and colleagues, “predominantly human-capital rich rather than financial-capital rich.”²⁸ Because their earnings are more similar to wages paid for labor than they are to a return on invested capital, principles of economic neutrality would tax this income as wages.

Research based on an anonymized sample of actual tax and information returns concluded that “the results suggest it is unlikely that large increases in capital and labor investments occurred due to the deduction in the first years it was available.”²⁹ Specifically, the study found “no evidence that section 199A changed investment among eligible firms relative to ineligible firms” and no evidence of a change in employment or wages paid using data that compared S corporations that did and did not qualify for the tax break in the first two years the provision was in law.³⁰ Further analysis found no evidence of an increase in employment or wages paid in 2020 or 2021, a period that the authors note overlapped with the COVID-19 pandemic, and small but mixed impacts on investment in 2020 and 2021, which the authors note “suggest it is unlikely” that the tax break spurred large increases in investment in the short or medium run.³¹

Proponents of 199A argue that it was needed to level the playing field with respect to the taxation of C corporations and pass-through businesses in light of the 2017 tax act’s corporate tax rate reduction.³² Research published by the American Enterprise Institute compared pass-throughs to C corporations using three measures of taxation—the effective statutory tax rate, the marginal effective rate, and the average tax rate.³³ The study, which takes state personal and corporate income taxes and the federal net investment income tax into account, found that by nearly all measures, the effective tax rate paid by pass-throughs was lower than that of C corporations even without the benefit of the 199A deduction.³⁴ Other research examining the question of parity concluded that the pass-through deduction “benefits primarily high-income owner-managers and undermines the equity and efficiency of the tax system,” while enhancing “the ability of owners of close corporations and pass-through businesses to recharacterize labor income as capital income and to avoid employment taxes.”³⁵

To the extent parity concerns remain, pass-through businesses can easily convert to C corporation status and be taxed at the corporate rate.³⁶ However, there is no evidence that significant numbers of pass-throughs have done so since the passage of the Tax Cuts and Jobs Act (TCJA), and observers note that the pass-through structures continue to offer significant benefits relative to C corporation status.³⁷

Tax-motivated gaming helped fuel the rise in the share of economic activity occurring through pass-through entities. Even before the passage of the 2017 tax act, pass-throughs could seek to game the tax system by minimizing the share of distributions subject to payroll and payroll-related taxes. These opportunities arose because, in addition to avoiding the corporate income tax, pass-through profit distributions received by “active” partnerships and S corporation shareholders are exempt from payroll and self-employment taxes (SECA) and the net investment income tax (NIIT) that apply to dividend income received by high-income individuals.³⁸ While the law exempts “passive” partners and S corporation shareholders from SECA, the distributions they receive are subject to the NIIT, and the law requires active S corporation owners to be paid a wage that meets reasonable compensation standards.³⁹ However, the Congressional Research Service notes:

The owners of limited partnerships and S corporations—two forms of business known as ‘pass-throughs’ and that are not subject to the corporate income tax—may be able to avoid the NIIT if they are actively involved in the business. Such owners may also be able to avoid the additional 0.9% Medicare tax that applies to wages and self-employment income above $200,000 for single filers and $250,000 for married individuals filing jointly.⁴⁰

The 2017 tax changes and enactment of 199A expanded opportunities for gaming to maximize the amount of income considered QBI. A study by economists at the U.S. Department of the Treasury and others found evidence that pass-throughs recharacterized certain payments in a manner “in line with the incentives created by 199A.”⁴¹ Specifically, the researchers found a substantial decline in guaranteed payments to partners, which are not eligible for the 199A deduction, while the payout of profits, which do qualify for the deduction, increased; this provided evidence of gaming to take advantage of the tax break.⁴² The same study found modest evidence of S corporations modifying payments to shareholders in order to maximize 199A deductions or changing their reported industry in a “manner consistent with the incentives of TCJA.”⁴³

Other research, authored by Princeton University, Department of the Treasury, UC Berkeley, and University of Chicago economists, found evidence of significant gaming even before the advent of 199A, with owners recharacterizing earnings formerly paid as wages as profits.⁴⁴ Their research assumes that 17.7 percent of the decline in the labor share of corporate income is “due to tax-motivated growth of S corporations.”⁴⁵ They also find evidence of substantial recharacterization among partnerships.⁴⁶ Together, they find that close to one-third (31.9 percent) of the reduction in the labor share of income reflects the rise of pass-throughs.⁴⁷ Interestingly, the previously cited research by Lucas Goodman and colleagues found no evidence that employers shifted workers to independent contractor status so that contractors could claim the new deduction.⁴⁸

Underreporting of business income subject to the personal income tax (pass-through income) accounts for a substantial fraction of the tax gap—taxes that are legally owed but not paid. In 2021, the most recent year for which IRS projections are available, pass-through income accounted for $182 billion of the estimated $688 billion gross tax gap. (see Figure 8)⁴⁹ Underreported self-employment taxes, owed by self-employed individuals, accounted for an additional $68 billion of the gap.⁵⁰ Taken together, these lost revenues accounted for more than one-third—36 percent—of the estimated gap.

The magnitude of the gap has been exacerbated by a decade of disinvestment and IRS budget cuts prior to the passage of the Inflation Reduction Act in 2022.⁵¹ Continued underfunding took a steep toll on the IRS’ ability to respond to the rise of large partnerships, which increased by 70 percent from 2010 to 2019.⁵² As a result of understaffing, the IRS was only able to audit 0.1 percent of large partnerships even though they accounted for a significant fraction of the tax gap.⁵³ Now, with the infusion of additional funding, the IRS has begun to target large complex partnerships. Using cutting-edge artificial intelligence and data science tools, the agency has opened examinations of 76 of the nation’s largest partnerships in a cross-section of industries, including hedge funds, real estate investment, large law firms, and others, using funds provided by the Inflation Reduction Act, and it has set a goal of increasing the audit rate for large, complex partnerships by nearly tenfold.⁵⁴

The deduction also widened racial disparities. A 2023 study by the Department of the Treasury’s Office of Tax Analysis estimates that the benefits of the pass-through deduction disproportionately benefited white families.⁵⁵ This study found that white families accounted for 90 percent of the benefits of the pass-through deduction but only two-thirds of tax-filing families in fiscal year 2023.⁵⁶ By contrast, Black families, 11 percent of filers, received just 2 percent of the benefit of the tax deductions. Hispanic families, 15 percent of all filers, received just 5 percent of the benefit of the deduction.⁵⁷

The pass-through deduction enacted as part of the 2017 tax act disproportionately benefits the wealthy, widens racial disparities, and fails to produce promised jobs or investment. It has encouraged gaming of the tax code to qualify for the deduction, sometimes illegally.⁵⁸ Congress should allow this costly and ineffective provision to expire as scheduled.

The author wishes to thank Samantha Jacoby, Mike Kaercher, and David Mitchell for their thoughtful comments and Kennedy Andara and David Correa for their assistance in the preparation of this report.